Litigation finance

In short

A friend of mine once told me the hardest part of a lawsuit was not the courtroom. It was the bill. If you are curious about litigation finance, here is the plain version. A funder pays the costs of a lawsuit for a person or company that has a claim. In return, the funder gets paid only if the case wins or settles. If the case loses, the funder usually gets nothing back. The funder's cut comes out of the money the case brings in, so it can be large. Anyone who looks at this field should read the funding contract line by line, ask a lawyer who does not work for the funder to review it, and learn what the rules are in the state where the case sits.

The whole of it

What it is

I once watched a small shop owner spend two years trying to collect on a broken supply contract. He was right, and his lawyer said so. But the legal bills kept stacking up, and he nearly gave up on a claim worth far more than the fees. That kind of story is why litigation finance exists.

Litigation finance means a third party pays for a lawsuit it is not part of. The money may cover lawyer fees, expert witnesses, court costs, or even the plaintiff's living expenses while the case drags on. The funder is not the plaintiff and is not the defendant. It is an outside backer with a stake in the result.

The money is usually called non recourse. That means the plaintiff does not have to repay the funder out of pocket if the case fails. The funder takes the risk of losing. Because of that risk, the funder asks for a share of any win, and that share can be big.

You may hear a few different names for the same idea. Some people say third party funding. Others say case funding or claim financing. Funders often work with businesses that have large commercial claims, and with law firms that want to cover the cost of taking on a pile of cases. Some funders also work with individuals, though those deals are a different animal and draw more worry from regulators.

How it works

If you are holding a claim and a stack of legal bills, here is the usual path. The claimant or the law firm brings the case to a funder. The funder studies the facts, the law, the likely size of a win, and how long things might take. Funders pass on many cases. That fact alone tells you a funder is not a charity. It is a business that wants to be paid for taking a gamble.

If the funder says yes, the two sides sign a funding agreement. That contract spells out how much money the funder will provide, what it may be spent on, and how the funder gets paid from any recovery. It also says how much say the funder gets over the case. Good agreements keep control of the case with the plaintiff and the lawyer, not the funder.

The payment is the heart of it. Funders are often paid in one of two ways, or in a mix. One way is a share of the recovery, such as a set percent of the winnings. The other is a multiple of the money the funder put in, such as two times the amount advanced. Many deals pay the funder whichever number is larger. Some raise the funder's cut the longer the case runs, since a longer case ties up the funder's money for more time.

The order of payment matters too. In many deals the funder is paid first, before the plaintiff sees a dime. Then the lawyer's fee comes out. What is left goes to the plaintiff. This is why a case can win and still leave the plaintiff with less than expected. The plaintiff should ask for a clear picture of that waterfall before signing anything.

A funder may also want a say in whether to settle. That is a touchy point. The plaintiff and the lawyer owe duties to each other, and rules of professional conduct in each state shape what a funder may demand. The funding agreement should keep the decision to settle in the hands of the plaintiff.

The numbers, and where to find yours

The numbers here are not set by one national rule. They come from the contract, and they vary from deal to deal. So the first place to find yours is the funding agreement itself. Look for the funder's percent of the recovery, any multiple on the money advanced, and how those change over time.

Rules about who may fund a case and what must be disclosed do change by state and by court. Some states have passed laws on consumer legal funding. Some federal courts have local rules that ask parties to disclose who is funding a case. The place to check is the court's own rules and your state's statutes. For a federal case, the Federal Rules of Civil Procedure and the local rules of the specific district court are the primary sources. A lawyer licensed in the state can tell a person which ones apply.

Taxes are another number to chase. How a recovery is taxed depends on what the money is for. The Internal Revenue Service is the primary source for how federal tax law treats income, and a tax professional can say how it applies to a given case. The funder's share does not simply vanish before tax. That is a question for an advisor who sees the whole picture.

A worked example

Let me tell you about a woman named Dana. She runs a small trucking company and has a claim against a supplier who broke a contract. She believes the claim is worth $400,000. Her lawyers estimate the case will cost $90,000 to take through trial.

Dana cannot afford to pay $90,000 out of her own pocket and keep her trucks running. So she signs a funding agreement. The funder agrees to pay the $90,000. In return, the funder gets the larger of two amounts. One is 3 times the money advanced. The other is 30 percent of the recovery.

Now suppose Dana wins and collects the full $400,000. Here is the math, with every input shown. Three times $90,000 is $270,000. Thirty percent of $400,000 is $120,000. The funder takes the larger number, which is $270,000. That leaves $400,000 minus $270,000, or $130,000. Then her lawyer's fee comes out. If the lawyer takes 25 percent of the recovery, that is 25 percent of $400,000, or $100,000. Dana is left with $130,000 minus $100,000, which is $30,000.

Sit with that for a moment. A $400,000 win put $30,000 in Dana's pocket. The funder took $270,000 and the lawyer took $100,000. Her deal was not crooked. It was just expensive, and she might have missed that if she had only looked at the percent.

Now suppose Dana loses. The funder receives nothing and Dana owes the funder nothing, because the money was non recourse. She still faces her own costs, and she may owe the other side certain court costs depending on the rules. That is why the contract and the local rules both matter.

Where it goes wrong

I have noticed that people sign what they do not fully understand when they are tired and scared. Litigation finance has a few spots where that goes wrong.

The cost can run far higher than expected. The multiple and the time based increases can stack up. A deal that looks fair in year one can eat most of a recovery by year four. A case that settles late may cost much more than one that settles early.

Control can slip away. A badly written agreement may give the funder a voice in strategy or settlement. The lawyer owes loyalty to the client, not the funder, and any deal that blurs that line is a red flag worth a second opinion.

Disclosure can bite. Some courts require parties to say who is funding a case. Others do not. A plaintiff who assumed the deal stayed private may find out otherwise. Privacy of the funding documents is also not guaranteed in every court.

Consumer deals carry extra risk. Funding offered to individuals, often called pre settlement advances, can carry steep charges. Some states regulate them and some do not. A person in need of cash is the easiest person to take advantage of, so extra care is wise.

And the case may simply fail. The funder takes that risk, but the plaintiff loses the chance at a recovery and may have given up rights along the way. Not every claim is a good candidate. Funders pick the strong ones, so a rejection can tell a plaintiff something useful about the claim.

Questions to answer before you leave this page

Do you know exactly how the funder gets paid, and have you worked the math with your own numbers in the way Dana's was worked above? Have you found out whether the funder takes a share, a multiple, or the larger of the two, and how that changes if the case runs long? Who decides whether to settle, and does the contract keep that choice with the plaintiff? In what order does the money flow when a case ends, and how much would be left for the plaintiff after the funder and the lawyer are paid? Does the court hearing the case, or your state, require anyone to disclose the funding? Have you had a lawyer who works for you, and not for the funder, read every page? Have you asked a tax professional how a recovery would be treated? And finally, have you asked yourself whether the claim is strong enough, and the need real enough, to justify giving up a large slice of the prize?